Fixed Income Investments - The Term Structure of Interest Rates

There are three main theories that try to describe the future yield curve:

Pure Expectation Theory: Pure expectation is the simplest and most direct of the three theories. The theory explains the yield curve in terms of expected short-term rates. It is based on the idea that the two-year yield is equal to a one-year bond today plus the expected return on a one-year bond purchased one year from today. The one weakness of this theory is that it assumes that investors have no preference when it comes to different maturities and the risks associated with them.

Liquidity Preference Theory: This theory states that investors want to be compensated for interest rate risk that is associated with long-term issues. Because of the longer maturity, there is a greater price volatility associated with these securities. The structure is determined by the future expectations of rates and the yield premium for interest-rate risk. Because interest-rate risk increases with maturity, the yield premium will also increase with maturity. Also know as the Biased Expectations Theory.

Market Segmentation Theory: This theory deals with the supply and demand in a certain maturity sector, which determines the interest rates for that sector. It can be used to explain just about every type of yield curve an investor can came across in the market. An offshoot to this theory is that if an investor wants to go out of his sector, he'll want to be compensated for taking on that additional risk. This is known as the Preferred Habitat Theory.

Implications of the Yield Curve for the Yield-Curve Theories

1. Pure Expectation TheoryAccording to this theory, a rising term structure of rates means the market is expecting short-term rates to increase. So if the two-year rate is higher than the one-year rate, rates should rise. If the curve is flat, the market is expecting that short-term rates will remain low or hold constant in the future. A declining rate-term structure indicates the market believes that rates will continue to decline.

2. Liquidity Preference Theory Under this theory, the curve starts to get a little bit more bent. With an upward sloping yield curve, this theory really has no opinion as to where the yield curve is headed. It could continue to be upward sloping, flat, or declining, but the yield premium will increase fast enough to continue to produce an upward curve with no concerns about short-term interest rates. When it comes to a flat or declining term structure of rates, this suggests that rates will continue to decline in the short end of the curve given the theory's prediction that the yield premium will continue to increase with maturity.

3. Market Segmentation TheoryUnder this theory, any type of yield curve can occur, ranging from a positive slope to an inverted one, as well as a humped curve. A humped curve is where the yields in the middle of the curve are higher than the short and long ends of the curve. The future shape of the curve is going to be based on where the investors are most comfortable and not where the market expects yields to go in the future.